Creditor Rights, Implicit Covenants, and the Quality of Accounting Information

We study a 2013 court decision that enhanced creditor control rights in Israel by allowing creditors to force companies in distress into bankruptcy. Following the ruling, we observe a pronounced increase in the reported net worth of the firms affected by it, as some of them increased their net worth by raising new equity. We also find, however, that affected firms changed their accounting policies, increasing the use of long-term discretionary accruals and reducing the extent of accounting conservatism. As a result of these accounting changes, we document a decline in the informativeness of the affected firms’ financial reports. We conclude that, the benefits from empowering creditors may be mitigated by unintended consequences in the form of increased incentives for borrowing firms to adopt aggressive accounting practices, which, in turn, lead to a reduction in the quality of information available to bondholders.